Question

Year	Potential Real GDP	Real GDP	Price Level	Federal Funds Rate
2006	$15.3 trillion	$15.3 trillion	90.1	5.0%
2007	$15.6 trillion	$15.6 trillion	92.5	5.0%
2008	$15.9 trillion	$15.6 trillion	94.3	1.9%
2009	$16.1 trillion	$15.2 trillion	95.0	0.2%
2010	$16.3 trillion	$15.6 trillion	96.1	0.2%
2011	$16.5 trillion	$15.8 trillion	98.1	0.1%
2012	$16.7 trillion	$16.2 trillion	100.0	0.1%
2013	$17.0 trillion	$16.5 trillion	101.6	0.1%
2014	$17.3 trillion	$16.9 trillion	103.6	0.1%
2015	$17.6 trillion	$17.4 trillion	104.7	0.1%
2016	$17.9 trillion	$17.7 trillion	106.8	0.4%
2017	$18.2 trillion	$18.1 trillion	107.8	1.0%
2018	$18.5 trillion	$18.6 trillion	110.4	1.8%

a) Does the AD curve shift to the right more or less than the LRAS curve in a dynamic AD-AS model from 2006 to 2007? Explain why verbally.

b) Explain why the Federate Funds Rate declines from 2007 to 2009 using Taylor Rule. Based on the Federate Funds Rate data in the table, explain the limitation of monetary policy that is implemented through open market operation during severe recession.

c) Suppose a military operation that costs $200 billion in 2011 can help the real GDP recover to $16.2 trillion one year earlier. What is the minimal required MPC of households in the Aggregate Expenditure model if there is no tax wedge on household income? What if the tax wedge is 1/3 of the pretax household income? What is the difference between the answer based on the Aggregate Expenditure model and the answer based on the static AD-AS model.

d) There was large fiscal stimulus during 2009-2011. People believe that fiscal stimulus is more powerful in 2011 compared to 2017. Explain why this can be true using the Federal Funds Rate data.

Answer 1

a) The shift in the AD curve and LRAS curve in a dynamic AD-AS model is same from 2006 to 2007.
The AD curve moves by $0.3 trillion (15.6 - 15.3 = 0.3 trillion real GDP) and also the LRAS curve (potential real GDP). It is due to the fact that as the price level has increased, the federal funds rate has remained constant at 5% in both the years 2006-2007.

b) Taylor rule states that Fed should lower the rates when GDP growth is slow and below potential. From 2007 to 2009, the real GDP (15.6, 15.6, 15.2) was well below the potential GDP (15.6, 15.9, 16.1) respectively.
In the year of 2009, there was difference of $0.9 trillion (16.1 - 15.2 = 0.9).
Therefore, the Federal Funds rate declined from 5% to 0.2%.

It is mainly because of the Fed's expansionary monetary policy implemented by the way of open market operations at the times of recession in the economy. But, its major drawback or limitation we can say is the price level which is rising. From the data above, we can infer that the price level rises continuously each year from 92.5, 94.3, 95.0 respectively from 2007-2009. Because of this rise in the price levels the savings of the consumers are largely affected in an economy.

c) Now, assuming a military operation that costs $200 billion in 2011 can help the real GDP recover to $16.2 trillion one year earlier. The minimum required MPC of households in case of no tax wedge for households should be equal to the aggregate expenditure.
And, with tax wegde, it should be equal to C + t. With a dynamic model, aggregate demand would reduce with tax wedge, moving the curve leftwards thereby decreasing the price level and the output level (real GDP).

d) Now, There was large fiscal stimulus during 2009-2011. People believe that fiscal stimulus is more powerful in 2011 compared to 2017. During this fiscal stimulus of 2009-2011, the Federal Funds rate was consistently falling from 0.2, 0.2 to 0.1% respectively. The gap between potential real GDP and real GDP was rising and the price level increasing. A falling interest rate was necessary to increase the investments in the economy, leading to more output.